What's the best retirement drawdown strategy?

How much can you safely withdraw from your retirement savings each year? That's a critical question for millions of working Americans who'll be retiring with 401(k) balances and little or no benefits from traditional pension plans.

Drawing down your assets in retirement is one of the trickiest retirement planning challenges because you face several key unknowns:

How long you'll live

What returns your investments will earn

How much inflation you'll experience

How much money you might need for living expenses, particularly medical expenses in your later years.

The challenge is that you can outlive your assets, experience poor investment returns or withdraw too much. On the other hand, if these possibilities intimidate you into withdrawing modest amounts, you might not enjoy your retirement to the fullest, and you could end up dying with a big pile of money you could have spent.

But you can't just throw up your hands and do nothing, or worse, withdraw whatever you feel like to meet your living expenses without having a specific strategy. The smartest move is to carefully select a method for investing and drawing down your assets so that they last the rest of your life, no matter how long you live.

You can gain valuable insights into this critical task from a recent study that analyzed various drawdown strategies. The study, prepared by the American Institute for Economic Research (AIER) and titled "From Savings to Income: Retirement Drawdown Strategies," analyzed eight different methods, which fell into three categories:

Constant dollar amount, for which you select an annual dollar amount to withdraw and adjust it for inflation, without regard to investment returns throughout retirement. The well-known 4 percent rule is one example of a constant dollar method.

Constant percentage, for which you withdraw a fixed percentage of your remaining assets each year, so the amount of your withdrawal is adjusted to reflect investment returns.

Increasing percentage approach, for which you withdraw an initial percentage of savings and then adjust that percentage upwards throughout retirement. The required minimum distribution that's applied to IRAs and 401(k) accounts is one example of an increasing percentage approach.

For each of the eight drawdown strategies, the study considered 12 starting withdrawal amounts, resulting in 96 combinations of strategy and drawdown amounts. The study then used an historical approach for analyzing the effectiveness of these methods: How would they have fared for every possible 35-year retirement period starting in January 1928?

The underlying assumption is that if a particular drawdown method wouldn't have failed for most or all of these periods, then it's adequately stress-tested because investment history since 1928 has included both good and poor years regarding stock returns, interest rates and inflation.

Here are the study's main conclusions:

No obvious winning strategy can be found across the spectrum of historical market returns and inflation. The success of a particular strategy depends significantly on investment returns that have historically been very erratic. Events beyond an individual's control play a big role in determining if a particular strategy is viable.

The first five to 10 years of retirement have a significant impact on long-term success. Modest withdrawals early in retirement provide a better chance of success over the retirement lifespan. This is a good argument for working part-time in your early retirement years to enable modest withdrawals from savings while you're still able to work.

A flexible drawdown strategy leads to better simulated outcomes. A strict application of the 4 percent rule, where you stick to the programmed withdrawal amounts and ignore investment returns, often results in depleting assets in poor investment climates. It's better to have a strategy that increases withdrawal amounts following good investment experience and reduces withdrawals when returns are poor.

A prudent starting point is 3 to 5 percent of assets. Initial drawdowns above 5 percent should be considered only if you can tolerate substantial reductions in future withdrawal amounts should returns be poor. Initial drawdowns below 3 percent are justified only if you're very risk-averse or if you expect future returns to be very low.

The study didn't consider annuities, which will be the subject of a future report. With an annuity, you can remove three of the four uncertainties mentioned above: how long you'll live, future investment returns and inflation. You can buy an inflation-adjusted annuity that guarantees a monthly retirement income for the rest of your life, no matter how long you'll live.

Earlier this year, such an annuity would result in a payout ratio of 5.1 percent for a 65-year-old man, 4.7 percent for a 65-year-old woman and 3.9 percent for a 65-year-old couple. These payout ratios are within the 3 to 5 percent range for prudent drawdown strategies. The trade-off: With these annuities, you don't have access to your savings, and there's no possibility of a legacy to children or charities.

How can you put together all these complex results to create a strategy that works for you? One reasonable approach is to buy a large enough guaranteed lifetime annuity that, when combined with Social Security benefits, covers your basic living expenses.

Then you can invest and draw down the remainder of your savings to pay for discretionary expenses, such as travel, hobbies and gifts. This way, you don't need to worry too much about stock market crashes or living too long.

In essence, developing a retirement income strategy is part art, part science. Learn all you can about the various methods of generating retirement income, with the AIER report being a good source and a good place to start. Then go ahead and enjoy your retirement, knowing you're doing the best you can.

View all articles by Steve Vernon on CBS MoneyWatch»
Steve Vernon helped large employers design and manage their retirement programs for more than 35 years as a consulting actuary. Now he's a research scholar for the Stanford Center on Longevity, where he helps collect, direct and disseminate research that will improve the financial security of seniors. He's also president of Rest-of-Life Communications, delivers retirement planning workshops and authored Money for Life: Turn Your IRA and 401(k) Into a Lifetime Retirement Paycheck and Recession-Proof Your Retirement Years.